Two proposals omitted from the Securities and Exchange Commission’s final private funds regulation package – seen as big wins for the industry – may actually signal that the regulator plans to enforce the spirit of them.
That’s because the regulator had the power to enforce the proposals, which would have banned accelerated monitoring fees and indemnification clauses in fund documents, all along, officials there believe.
“In a change from the proposal,” regulators say in the 660-page adopting release approved by a divided commission last week, “we are not adopting the prohibition on fees for unperformed services because we believe this activity generally already runs contrary to an adviser’s obligations to its clients under the federal fiduciary duty. We are also not adopting the indemnification prohibition that we proposed because much of the activity that it would have prohibited is already prohibited by the federal fiduciary duty and antifraud provisions.”
Many saw the final rules as softer on the industry than expected, and a sign chairman Gary Gensler flinched in his plan to overhaul the private funds market. But that may be the wrong way to look at things. “The SEC is clearly communicating that they think they already have the tools to prohibit existing practices and add others,” says Marc Ponchione, a former commission lawyer who’s now a partner with Debevoise & Plimpton. “The SEC does not include items in a release that it does not want the industry to notice.”
The commission hangs its case against accelerated fees and indemnification clauses on a 2019 guidance document published under then-Republican chairman Jay Clayton. In it, regulators say that investment advisers owe a duty of care and duty of loyalty to their investors that permeates the entire relationship between adviser and investor. The form relationships take will differ depending on the type of investment and clients, but one thing should be clear, regulators said then: an “adviser’s federal fiduciary duty may not be waived… A contract provision purporting to waive the adviser’s federal fiduciary duty generally, such as (i) a statement that the adviser will not act as a fiduciary, (ii) a blanket waiver of all conflicts of interest, or (iii) a waiver of any, specific obligation under the Advisers Act, would be inconsistent with the Advisers Act, regardless of the sophistication of the client.”
That the SEC under Gensler specifically pointed that guidance out when publishing the final rules could indicate it’s going to be taking those practices seriously – and by not including the proposals in the final version, it may make it harder to challenge in future lawsuits against the package.
“It’s clearly setting the stage for future battles,” Akin partner Brian Daly says. “The SEC enforcement division will have the ability to shape this position through selective actions. Whatever happens to the private funds rule itself, whether successfully challenged, unsuccessfully challenged, or not challenged at all, the commission’s position on a withdrawn proposal will still be there.”
Accelerated monitoring fees have been part of SEC enforcements in the past, but the proximate cause of SEC action has been lack of pre-commitment disclosure. Blackstone settled with the SEC for $39 million in 2015 over alleged lack of disclosure of such fees, for example.
But the SEC’s recent statement indicates that the fees themselves might be seen as breaching fiduciary duties in some cases – though which exact practices are frowned upon is still unclear. Many firms accelerate monitoring fees to portfolio companies when they are sold earlier than planned as a means of maintaining revenue they would have made if they hadn’t sold – essentially providing an incentive to sell earlier, and theoretically increase IRR for investors.
But charging such fees also reduces the value of the asset, and so many mangers include management fee offsets at the fund level – often 80 percent up to 100 percent of the accelerated monitoring fees collected, in order to save investors from taking the hit.
It’s unclear if these circumstances fit the SEC’s definition of bad business. In 2018, industry group the Association for Corporate Growth wrote that “even funds with a 100 percent offset provision do not necessarily insulate themselves from scrutiny if there are excess fees retained by the fund manager where no further fee offset can be applied upon fund liquidation.”
‘How do we get there?’
It is widely expected that the SEC will face lawsuits over the new rules. But because regulators are dropping the old guidance into the new rules as dicta and not as final rules, it may make it harder to challenge frontally. In any case, unless and until someone sues – and then gets a federal judge to agree with them on the merits of their case – fund managers ought to read the guidance language as a warning. The good news is that neither accelerated fees nor indemnification clauses appear to be banned outright. The bad news is fund managers may have to do a lot more work to justify them.
“In explaining why they abandoned the accelerated fees in the final rule, the SEC said that engaging in these activities may be a breach of fiduciary duty,” Schulte, Roth & Zabel partner Allison Scher Bernbach says. “The question still open is whether disclosure is enough to cure that breach, or whether reimbursing fees for services that you don’t end up providing is enough to cure a deficiency.”
David Blass is a partner with Simpson Thacher. He says one workaround for funds that want to use accelerated monitoring fees might be to waive management fees. But Blass says he’s more troubled by the cumulative changes the SEC is taking towards private fund regulation.
“This is an initial salvo from the SEC in establishing a more retail-type framework for private funds,” he says. “It’s got standardized reporting, standardized rights for investors. It’s retail regulation of private funds.”
There was no shortage of fees and expenses that regulators wanted to prohibit. In the 18 intervening months between proposal and final rules, the prohibited activities became restricted activities, and regulators carved out exemptions for “legacy” agreements.
Red light green light
Yet the new restrictions are daunting. For instance, under the new rules, a fund manager can ask his or her investors to cover the costs of an SEC investigation, but he or she must get a majority of those investors to sign off on the expense. If the investigation leads to sanctions under the Advisers Act, the fund must repay the expenses. In principle, that’s a form of “relief” from what the SEC proposed in early 2022. In practice, it’s relief in name only, says Elizabeth Shea Fries, a partner with Sidley Austin.
“How do you get informed consent?” she asks. “Do you go to all your investors and say, ‘I’m being investigated for this and here’s what it’s going to cost?’ Even if you do that, what investor is going to say, ‘Sure?’”
Several of the restricted activities rules apply to exempt private funds. On the one hand, they’ve just been given a first-of-its-kind green light from federal regulators to charge certain fees and expenses. On the other hand, the disclosure/consent provisions can be complicated.
“The restricted activity rules, they each have their own required process for disclosure or consent, like each activity requires a different adventure to satisfy the conditional permissibility,” Troutman Pepper partner Genna Garver tells Private Funds CFO.
“It’s unfortunate that it seems really complicated. It’s a lot to keep straight, especially for non-registrants without a formal compliance program or a dedicated compliance officer.”
That’s why the question of fiduciary duty matters so much, legal experts say. If mere negligence is a breach of fiduciary duty, it’s not hard to imagine regulators – or even plaintiff’s lawyers – feasting on funds’ bad investment choices, or bad investment luck.
Gensler’s spokespeople have not responded to an emailed request for clarity on what the new rules’ guidance language means for accelerated fees or indemnification.
Hedge clauses, harmful or not
If SEC exam or enforcement staff are going to use the 2019 guidance in the new private funds rule to crack down on indemnification, they’ve already warned funds where they’re likely to start.
“The SEC has been getting very, very attentive lately to hedge clauses,” Eversheds Sutherland partner Issa Hanna says, referring to common language in partnership agreements whereby the LPs agree not to hold the fund manager liable for conduct unless it’s grossly negligent, or unless the fund has engaged in reckless or willful misconduct. “That to me is something that private fund advisers have to pay attention to.”
In the SEC’s adopting release, regulators cite some two dozen enforcement cases that they say help justify the sweeping changes. Most of them involve private funds. One exception is footnote 779, which cites the case against New Jersey-based retail investment adviser Comprehensive Capital Management. In January 2022, Comprehensive agreed to pay more than $375,000 to settle SEC claims that its boilerplate hedge clause could lead investors to believe they were waiving all causes of action against them.
In words similar to what’s now in the private fund rules, regulators had this to say about Comprehensive’s hedge clause: “The Advisers Act establishes a federal fiduciary duty for investment advisers. An adviser’s federal fiduciary duty may not be waived, though its application may be shaped by agreement. Moreover, advisory agreements may not misrepresent, or contain misleading statements regarding, the scope of an adviser’s unwaivable fiduciary duty and lead a client to believe incorrectly that the client has waived a non-waivable cause of action against the adviser provided by state or federal law. This is true even if there is a disclaimer (sometimes known as a ‘savings clause’ or ‘non-waiver’ disclosure) stating that compliance with the state or federal securities laws is not waivable.”
And two days before the vote on the new private fund rules, the commission announced a fresh settlement with Titan Global Capital Management. Although Titan advises hedge funds, it was dinged for its behavior with retail investors. It’s a first-of-its kind enforcement action stemming from the SEC’s onerous marketing rules, but Titan was also written up for hedge clauses that were too broadly worded. Titan’s hedge “language, when read in its entirety,” regulators said, “is inconsistent with an adviser’s fiduciary duty and the commission statement because it may mislead Titan’s retail clients into not exercising their legal rights. Accordingly, Titan’s hedge clause violates Section 206(2) of the Advisers Act.”
For Hanna, the message couldn’t be clearer. “They don’t even have to show investor harm to bring a hedge clause case,” he says. “People have to go back to their governing documents. They can’t let it sit. They have to make clear they’re not asking anyone to waive fiduciary duty. People need to be paying attention to this.”
Indeed, regulators are already examining funds about their hedge clauses. “Lastly,” the SEC said in announcing its 2023 exam priorities earlier this year, “examinations will review whether firms have customer or client agreements that purport to inappropriately waive or limit their standard of conduct, such as through the use of hedge clauses.”
It may mean that funds have to go back to their governing documents and partnership agreements to make sure their hedge clauses aren’t written too broadly, Troutman’s Garver says.
“Yes, the SEC will likely be scrutinizing your hedge clauses more closely,” she says. “Do you have to carve out, expressly, breaches of the federal fiduciary duty and actions not compliant with the Advisers Act, or any rule, regulation, or order thereunder? It’s unclear how this guidance will change market terms or what magic language must be included with respect to fiduciary duty and the Advisers Act.”
‘An overwhelming amount of regulation’
Onerous as the work ahead due to this guidance may seem, it’s only a fraction of the work ahead for private fund managers. Under the new rules, registered fund advisers now must publish and circulate quarterly statements on their fees and expenses. There are 16 different categories listed in the new rules, and funds aren’t allowed to skip the small stuff. A 25 percent stake in a portfolio company makes that firm an “affiliated,” and those expenses will have to be calculated, too.
“Given the legacy status of some of the new requirements and the changes from flat prohibitions to restrictions, some of the new rules will be less disruptive than they could have been,” says Gail Bernstein, general counsel of the Investment Adviser Association. “But even with these changes, they will still be a huge lift for private fund managers and will significantly raise the costs for start-up and small managers.”
More is coming. Gensler has promised to bring final rules on asset custody (it’s now called “safeguarding”), on outsourcing, on cybersecurity and artificial intelligence, and on ESG disclosures. Any one of those rules could be considered epoch-making in their own terms.
“It’s really an overwhelming amount of regulation coming at private funds,” says former SEC exams chief Carlo di Florio, who is now the global advisory leader for compliance consulting firm ACA Group. “SEC Chair Gensler had said right from the beginning that he thought this was a market that was too opaque, and he wanted to bring transparency, efficiency, and competition to the private markets. Private funds have been on their heels right from the start of Gensler’s term.”